Leverage moves down the investment scale

Last year was marked by “great returns and cashflows” for middle-market private equity deals, according to Jonathan Russell, head of buyouts at 3i.

These comments illustrate the positive mood at many of the leading mid-market buyout houses in Europe, although there are some concerns about rising prices and growing levels of debt. The trend that has characterised the upper end of the buyouts market is moving down the investment scale.

“Prices for some of the larger deals have really surprised people – such as ABN AMRO’s purchase of the Priory Group last year – but we haven’t seen quite that increase in the mid-market yet,” said one investment executive.

Competition in the mid-market has increased across Europe, although it is fiercer in the UK than in less mature private equity markets. Germany has seen a big increase in mid-market players in the past year to 18 months, noted Philipp Schwalber, an investment executive at HgCapital.

The middle market is far from homogenous. Paul Marson Smith, chief executive of lower middle-market investor Gresham, described this segment as inefficient and discreet, which meant that firms with strong local relationships could generate very high returns.

“It’s a good place to be because it’s where private equity has the most scope for adding value and being creative, much more so than in the very large deals,” he said.

Debt levels have also increased in the middle market, but not as much as in larger deals, according to Marson Smith. Excessive leverage in that sector could cause problems because it was high-growth businesses that were targeted. Too much debt could negatively affect growth prospects and returns offered by portfolio companies.

“In the last two years we’ve had 18 exits at an average of 3x money,” he said, noting that in the case of Penn Pharmaceuticals, exited in December 2004, the return was 8.3x the original investment.

“These kinds of returns would be threatened by excessive leverage because over-mortgaging cashflows means companies are less able to exploit the opportunities they face or handle the knocks,” said Marson Smith. “That’s why we look for an appropriate financing structure for each transaction. In the case of Penn, for example, there was no leverage at all.”

Simon Havers, managing director at lower mid-market firm Granville Baird, played down the debt issue, saying that the debt multiples his house was being offered were little different to those of three to four years ago.

But others acknowledged that multiples had increased. Christopher Masek, a partner at Industri Kapital, said of the French market: “There’s a lot of competition for assets and leverage is probably too much, but that should start coming down in 2006.”

He noted, however, that it was not so much that debt to equity ratios had changed, but rather that houses were able to borrow at higher multiples and thus pay more for assets. “[Firms are typically] still putting in around 30% of equity in the investments but are now able to borrow, say, 4.5x Ebitda for the senior portion of the debt,” said Masek. “Although a lot depends on the deal and the sector, for certain transactions you can get 7x Ebitda.”

Markus Golser, a partner at Graphite Capital, observed that there had been an increase in absolute debt because multiples had increased, especially in fashionable sectors such as retail, consumer products and healthcare.

When it came to returns, Granville Baird’s Simon Havers believed the mid-market generally offered higher returns than the very large deals. “According to BVCA performance statistics for 2004, returns for the mid-market were 29.6% and for the large deals 19.7%,” he said, although noting that the measure was to some extent artificial as it was impossible to invest in a private equity fund for just one year.

This differential in returns, Havers said, was because the lower the deal size, the higher the potential return should be, in theory. “If the money multiples were the same, then everyone would choose to be at the top end, where you could earn more in absolute terms,” he said.

But not everyone is convinced that returns between the two markets are that different. HgCapital’s Schwalber said that historically the mid-market in Germany had provided better returns than the large deals but that that could be changing as a result of increased competition for assets.

“We’ve seen a lot of excellent exits in Germany but there has been more competition in recent years, while in the large deals there are more club buyouts, which is perhaps reducing competition in that market,” he said.

Graphite’s Markus Golser argued that at the larger end of the market deals were focused on more stable and established companies, which meant returns were more predictable. In the mid-market, investments were more volatile.

For example, there were investments such as noodle bar chain Wagamama, which was sold by Graphite to Lion Capital last June for a return of 10.2x the original investment.

“When you average it all out, there’s probably not that much difference between the mid-market and large deals, but in the mid-market there’s probably a much wider variation in individual returns,” said Golser.

But what about future returns – will they not be lower given some of the very high prices being paid for assets today?

Tom Lamb, co-head of Barclays Private Equity, sounded a cautious note, arguing that many of the impressive returns achieved in 2005 were based on the much lower prices that were paid for those assets three to five years ago. It would be much more challenging to achieve a similar investment return based on the much higher prices now being paid, Lamb said.

Jonathan Russell of 3i said: “There’s inevitably been pressure on prices, but we’re paying 7x Ebitda on average in our deals, so we’re not paying silly prices. If you have a good network and market access, you can still buy at sensible prices.”

He added that seeking out investments through other means than auctions also helped keep down the price, and that 75% of 3i’s acquisitions were not through auctions.

Because of increasing prices, many mid-market houses have found themselves moving up the deal chain to larger transactions. Russell sees this migration as a positive trend. “We can now do €1bn deals that have mid-market characteristics,” he said, adding that he was not aware of any house moving back down the deal value chain as a result of higher competition in the upper mid-market. “But you do get larger firms buying smaller assets sometimes when they see something they really like,” he said.

In terms of the challenges facing the mid-market, there is clearly a risk that the debt markets could turn, leaving some investments over-leveraged, said Marson Smith. Some executives also pointed to the trend of replacing amortisation debt repayment with bullet debt.

One of the implications of the change in debt structures is that in six or seven years a lot of companies would need to refinance this debt, said Schwalber, noting that under bullet repayment terms value creation through financial leverage worked more slowly.

The increased competition for assets has also led to some players “cutting corners” when it comes to acquiring companies.

“There have been several secondary sales in which the sale documentation has been based on the bank finance documents used in the original transaction, and there has been no auction or real due diligence put in place,” said one investment professional.

Houses have been willing to buy these companies without the usual information or due diligence because in the current heated environment they are looking for short cuts. But while houses can raise funds without too much trouble, things continue to look positive.

“Some houses have done better than others in fundraising but no-one has really struggled, as far as I know, and that wasn’t the case a couple of years ago,” said Lamb.

Of course, an economic downturn in Europe or more globally could impact significantly on the market. While he said he was optimistic that private equity would continue to perform well, even if wider economic conditions deteriorated, Gresham’s Simon Havers said he was particularly interested in export-oriented companies.

“The key note in the coming year for us and several others, I imagine, is to focus on businesses with an international mindset and sales, especially if they are selling to China,” he said.

For others, it will be the mid-market houses with a proven track record and strategy that are likely to succeed in the possibly less benign environment of the coming years.